Lecture 3 Revision - Important Concepts

Real Estate Valuation

Direct Comparison

• Simplest method
• Used when sales evidence is comparable enough to subject to allow direct comparison.
• Most popular method of valuation incorporated in the valuation of non income producing properties.
• Like with Like, Apples with Apples
• Perfect World Scenario – Real challenge is adjustments for items that are not comparable (no two properties the same)

Summation method

• Collation of value through the addition of constituent parts or components of a property.
• Used predominantly as a check method. Example:

• Land component treated as if it was vacant
• Building and improvements is their added value to the land (can be challenging to assess accurately – depreciated replacement cost)

Before and After

• Used to assess compensation as result of compulsory acquisition, easement or encumbrance
• Simply the difference in value before and after the imposition of the event
• Method requires two separate valuations
• One before and one after
• Can also be used in aggregating and/or subdividing properties

Hypothetical Development

• Used to assess land under-developed but has:
  • Highest and Best Use as a development site
  • Immediate potential for development
• Suited to assess englobo (in-globo) land
• Method starts at the end and works backwards
• Hypothetical Development Equation:
  • Value of Finished Product = land value + dev costs + finance costs + profit
  • Value of Land = Value of Finished Product – (dev costs + finance costs + profit)
• Suitable only for static residual value calculations (single phase developments)

Discounted cash flows

• Method involves assessing the present value of future cash flow
• Method based on subjective assumption
• Allows cash flow flexibility
• Useful in the assessment of complex and variable income properties
• Can be dangerous in the wrong hands – lots of assumptions

Units of Production

• Common application for Rural properties
• Carrying capacity, Beast area value
• Applied to specialised commercial properties
  • hotel liquor consumption
  • bed rate in boarding houses
  • Room rate in hotel / motel

Capitalisation method

• This valuation method is used for investment class properties
• This method has been widely accepted as being suitable for the estimation of Market Value.
• Under this method, the Future Sustainable Annual Net Income of the subject property is converted to a capital sum (or value) by a market derived multiplier.
• There is a basic assumption that the level of income will remain constant in perpetuity, or at least sufficiently long term to adopt a calculation of the income stream in perpetuity.

Capitalisation Rate

• Cap rate often referred to as yield or “All Risks Rate”

• It is a rate that represents all current and future expectations and benefits to be derived from a property.

• The rate can be used as a benchmark for the comparison of investments

• Benefits - very simple to use and easy to compare with other assets

• Challenges – integrity and availability of market data to derive rate

• The formula used for the Capitalisation Method is:

$$CV = \frac{NI}{I}$$

• Where:
  • $CV$= Capital Value
  • $NI$ = Net Annual Sustainable Income (also sometimes called Net Operating Income)
  • $i$ = Capitalisation Rate (or Yield)
• The valuer needs to establish:
  • The Open Market Rental Rate applicable to the property by reference to market rental evidence.
  • The Cap Rate by analysis of recent sales evidence.
• The factor is generally applied to the analysis/valuation of income streams (annuities) from real property held freehold in fee simple which are considered to be enjoyed in perpetuity.

Note the Cap Rate is a market derived discount rate BUT is different from discount rate applied in a Discount Cash Flow.

Capitalisation Rate – Years Purchase

• An alternate way of explaining the relationship between net income and property value is the number of years needed to buy the property.
• Years Purchase is the reciprocal of the capitalisation rate:

$$\frac{1}{\text{Capitalisation Rate}} = \text{Years Purchase}$$

For example, using the same figures as previously:

$$\frac{1}{0.08} = 12.5 \; \; \text{years purchased}$$

Shortcomings of the Capitalisation Method

• Data Errors:

  • This has been an application of the Capitalisation Method at its most basic level. In the real world, there is obviously a lot more data collection, analysis and adjustment to the numbers that needs to be effected.
  • In short, this method is simple to apply but is highly sensitive to data errors. Not only is there the difficulty of locating recently sold comparable properties, but there is the added problem of assessing their net annual income and an applicable cap rate, as much of this information is confidential.

• Reliability of Information:

  • The valuer must invest considerable time and effort in reviewing the financial facts applicable to the subject property. The most reliable information sources will be from other assignments undertaken by valuer and colleagues, and this may be limited in scope.
  • The valuer must therefore network with others in the industries and hope for a sharing of information. Even then, the available data may come from buildings with differences in age, condition, location, materials, quality of services and finishes, lease structures and management quality, to name a few.

• The Assumption of Sustainable Net Income:

  • The conventional practice is to estimate what a stabilised net annual income for the subject property will be. This assumes that this income level will “settle down” in perpetuity.

• Selection of the Cap Rate:

  • A minor error in establishing the Cap Rate will have a major impact on the estimated property value.
  • The Cap Rate is often referred to as an “All Risk Yield” because it incorporates allowances for every source of risk to which the investment is perceived to be exposed.
  • The component risks would include the “risk free rate”, inflation, anticipated interest rate movements, rental rate movements, vacancies, building expense variations, obsolescence, terminal value risk, etc.

• Despite its shortcomings, the Capitalisation method is widely used in the property industry, either as a primary or secondary valuation methodology.

• It is not universally popular however, as one unkind commentator observed: